My Own Private Housing Bubble

I'm about to pay way too much for a house, and I know it. Does that make me a fool?

Family Harford has just put in an offer for the house next door, to hoots of scorn from my colleagues, who know me as a bear among bears. It is true that the London housing market seems (who knows?) to be in the final stages of its biggest-ever bubble. But there are special circumstances involved here, one of which is that no rational economic actor disobeys an order from his wife.

My discomfort at having to make an offer put me to thinking that we often bungle our housing decisions. I am ever the champion of economic rationality, but even I would admit that there are exceptions. Buying a house is a rare event, and the stakes are mind-bendingly high. Calamity is, therefore, always possible.

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Most people do not seem to see the cost of a house in the same way that they see other prices. House prices are simply viewed through the lens of monthly repayments that either can or cannot be afforded. We spend time and money insuring ourselves against some losses, such as a malfunctioning washing machine, yet the value of the house we own (or the cost of the house we might someday want to buy) fluctuates by far more, perhaps on a daily basis. Nobody cares, nobody hedges the value of their homes—although it is not hard to do so—and nobody seems to compare the price with any meaningful alternative, such as retiring 15 years early.

We also become irrationally possessive, and not only of our homes. Behavioral economist Dan Ariely—author of an excellent new book, Predictably Irrational—once demonstrated this possessiveness with a clever experiment. He observed that tickets to see the top basketball games at Duke University are absurdly scarce. Students who want them must line up for weeks (they form teams and take turns). Even then, there is a lottery for tickets. Some win, and some lose.

Winners and losers alike line up devotedly and are chosen at random. The only difference is that winners, by chance, hold tickets in their hot little hands. And yet when Ariely phoned the losers pretending he had tickets to sell, they tended to offer around $175. Winners simply wouldn't sell to him for anything close: Their typical asking price was $2,400.

People are even less willing to sell if that means realizing a loss. Research by Terrance Odean, a professor of finance at University of California, Berkeley, suggests that stock-market investors tend to sell shares that have made money and keep poor performers, even though tax efficiency suggests the opposite strategy. The tendency is called "loss aversion"; people hold on to poor investments grimly, hoping for a turnaround.

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"If you can get attached to a stock, imagine how attached you can be to your house," Ariely told me in a telephone interview.

Other research suggests that high stakes can befuddle the brain. Ariely and his colleagues once offered payments of up to six months' salary to Indian peasants who could successfully complete certain mental or physical tasks. Modest stakes motivated excellence; super-high stakes simply caused nerves.

Sadly, none of this helps Family Harford very much. We'd like to buy the house next door, but if others offer irrationally exuberant bids, we won't get it. Nor will we be able to pick it up cheaply after the bubble bursts. In principle, that should be easy to do. In practice, that would mean somebody selling at a loss, a rare phenomenon.

And so, if we want the house next door, we must buy it now—even if it means outbidding irrational bidders. It's a tough job being the sole voice of reason in a crazy world, but somebody has to do it.